How Much Home Can I Afford?

Eddie Kim's parents made savvy residential real estate purchases in New Jersey 15 years before the housing bubble burst, so he was fully aware of how unique the housing boom was. After he married in March, his parents encouraged him and his wife to take a different approach than they did: Not to buy a home as "an investment opportunity or retirement portfolio, but just as a place where we can grow our future family," says Kim.

This strategy has made it even more important for Kim and his wife to carefully and soberly assess the question: How much home can I afford? They're using a conservative estimate of how much monthly income they can spend to buy a house because, as Kim says, they agree that they "would like to afford to go on vacations every so often and not be forced to spend our time off in our living room, living vicariously through commercials on TV."

Like most big questions in life, there's a quick answer and a long answer to how much house you can pay for. Both are helpful to think about so you'll buy a home with a mortgage you can afford.

The Quick Answer

The rule of thumb is that most potential homebuyers can afford to buy a home that costs between two and two-and-a-half times their gross annual household income. So, for example, if Rita Renter is looking to become a homeowner and she earns $50,000 a year, she can afford a home that would cost between $100,000 and $125,000.

For those who can afford to plop down a big down payment, and have light debt loads or none at all, a buying a home up to four times their annual income might be reasonable. While this quick estimate offers a helpful lens through which to eyeball how much home you can afford, there are other ways to look at it, and they involve ratios, history and costs.

The Long Answer

It's one thing to think about how much you might be able to spend on a home, it's another to think about how much you'll be allowed to. Or is it? Maybe the most comprehensive, helpful way to assess what you can afford is to look at it from a lender's perspective, which might be the most sober and insightful.

Mortgage lenders use two main calculations to decide whether you actually can pay them back: the front-end ratio and the back-end ratio. (They're not nearly as complicated as they might sound.)

The front-end ratio, or the housing expense ratio, is simply the percentage of your gross (that is, pretax) monthly income that will go toward paying the mortgage. Generally, conservative lenders want that to be less than 28 percent; others might push it to 30 percent or higher. But check with lenders to see what their actual thresholds are. (Since the housing bubble burst it's a lot harder to find lenders willing to accept a 40 percent ratio, though that's probably a good thing.) If you earn $5,000 per month, and the lender has a 28-percent threshold, the most they'd be comfortable with would be $1,400 ($5,000 x 0.28).

The back-end ratio, or the debt-to-income ratio, is the percentage of your gross monthly income that will go toward paying all of your debt obligations: mortgage, credit cards, child support, car and student loans, etc. Some lenders want your total debt payments to be less than 36 percent; others allow as much as 40 percent or more. If you earn $5,000 per month and your monthly debt obligations now are $300, or 6 percent of your gross monthly income, your back-end ratio will be 34 percent ($1,400 + $300). Since that's below the threshold of $1,800, or 36 percent ($5,000 x 0.28), you could be a good candidate for a loan.

Types of Loans

There are three main types of mortgage loans: conventional; FHA (Federal Housing Administration); and VA (U.S. Department of Veterans Affairs).

Conventional loans are the most common way to buy a home in the U.S., hence the name. They typically require a down payment of at least 10 percent and sometimes up to 20 percent, in addition to a pretty solid credit score. However, these mortgages present lenders fewer hurdles than the other two.

FHA loans are a bit more forgiving, in the sense that they require down payments as low as 3.5 percent and are usually a bit more flexible with credit scores. Their thresholds for front- and back-end ratios differ from conventional loans, though.

VA loans are great for U.S. military veterans and those now serving. Those who qualify don't have to make a down payment and aren't required to get private mortgage insurance.

That's a quick overview, but the takeaway is: Explore your loan options to make sure you find the best fit.

Potential homeowners also need to figure in the other costs associated with a mortgage, like property taxes, homeowners insurance and closing costs. It's also important to note that the house you buy will be considered by your lender as collateral on the mortgage loan. In other words, should you be unable to repay the loan, the lender can foreclose on your mortgage and seize the house.

Home-Related Costs

The mortgage isn't the whole story. Owning a home is expensive and it's crucial to know that from the get-go. Things like maintenance, utilities, furniture, and association fees are among the month-to-month costs that you'll incur along with the mortgage when you buy a home.

Use Your Weapons

There are tools to help you determine how much home you can afford, even beyond this guide. Mortgage calculators and home ownership calculators are easily found online and can narrow down how much house you actually can afford.

And use common sense. It's easy to get swept up by the ocean of numbers that figure into a discussion of affordability, but don't forget the basics. How much are you comfortable paying toward your home each month, really? Can big plans for the future affect your financial circumstances? How long do you plan on staying in the home? What would be the consequences of not being able to make your mortgage payments?

Owning a home is great, but carefully consider how much you're willing to give up for it. You might find that renting is your best option right now. Knowing what you want to spend might be worlds apart from knowing what you can pay, so use every resource you can to help determine how much you can afford to spend on a new home.